Bob’s View: The European drag

If you’re looking where to point for the recent market sell-off, blame Europe. The markets re-priced themselves largely because of the slowdown in Germany, along with the rest of the Continent.

While the U.S. markets have almost fully recovered from the sell-off that started in mid-September, the rebound in Europe still has a ways to go.

The United States was early in stimulating its economy, but Europe – and to a lesser extent Japan – has lacked the political will to turn their economies around. All this coincides with the slowdown in China that started last year.

The United States is clearly the largest economy in the world, and it’s still growing. Number two is China. They’re slowing. Number three is Japan. They’re slowing. Number four is Germany. And they are close to contraction.

Mario Draghi, the head of the European Central Bank, said in 2012 he would do whatever it took to defend the euro. Since then, he has proceeded to do almost nothing. As evidence, the bank recently announced that it was buying 1.7 billion euros ($2.2 billion) in bonds, which is far too small to have any impact on the European economy.

Central bankers in Europe are so phobic about spending. At the beginning of October, the European Central Bank came in with a stimulus program that was puny, and the markets yawned at it and said, “Really? You’re going to do whatever it takes, and that’s it?”

In October, the European Stoxx 600 index suffered its biggest setback since the financial crisis six years ago. At one point in October, the Standard & Poor’s 500 – which had been setting record highs all year – was down 8% from its September peak. By the end of the month, the S&P was back within 0.1% of its all-time high.

International stocks continue to lag U.S. stocks because of the strength of the U.S. dollar, which has recently plateaued because of inaction by the European Central Bank and the German government.

A stronger dollar tends to reduce the rate of return of international stock funds held buy U.S. investors. It’s widely anticipated that U.S. interest rates will gradually trend higher later next year while at the same time, interest rates in Germany and Japan could decline because of stimulus measures by the European Central Bank and the Bank of Japan.

Germany is bearing the brunt of the sanctions against Russia. The German economy has slumped precipitously. My sense is that German Chancellor Angela Merkel doesn’t have the backbone to create more government spending. It’s not Germany’s history. And it’s the only thing that’s going to turn it around there.

The European Central Bank is in strong talks now about stimulus measures. Seeing is believing, but the European markets have rebounded, which has led to our rebounds in the past couple of weeks.

We always say it’s all about earnings and interest rates. And that part of the story hasn’t changed.

Earnings for the third quarter are ahead of initial forecasts. We are paying average multiples for stocks, and Bloomberg is forecasting a 10% to 11% increase in profits for each of the next two years.

Furthermore, we have significant breadth in the market. Most of the sectors – outside of oil and gas – are doing pretty well right now. Of the 10 sectors that the S&P follows, nine are profitable.

And, we still see a lot of investors who are cautious. That’s good because the markets climb a wall of worry. If everybody’s optimistic, that means they’re all in, and there’s nothing to take the markets higher.

When you take a look at what causes bear markets, nine out of the last 11, it was the Fed raising interest rates to beat inflation down. And that’s not happening now.

In fact, the big surprise has been how many investors are still forecasting high inflation. They continue to be wrong. We started the year with the 10-year Treasury at 3%. Many Wall Street firms predicted that we would end the year at 3.5%. It currently is 2.3%. Bonds have done well this year. (Bond prices go up as interest rates go down.)

The markets typically do well as we head toward the close of the year. And we remain guardedly optimistic about the economic expansion, along with growth in the equity markets.

We’re not out of the woods yet. China continues to slow, as does Germany and the rest of the continent. It’s important to point out that the danger isn’t behind us.

The U.S. economy decoupled from much of the rest of the world in the 1990s. Our stock markets did well despite the Asian financial crisis. But no man is an island. You can’t decouple forever. Over time, you need healthy trading partners to trade. So we’ll need Europe to turn around. We’ll need China to turn around.

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